“Hindsight is 20/20” - we all love to say

Trying to asset allocate tactically by market is not easy. Passively’ owning the S&P 500 only this actually an active decision that forgoes...

TAKEAWAY OF THE WEEK

Let’s rewind to the early 70s:

Nixon was President. Mao was Chairman.Elvis was on tour.The first pocket calculator was released.Japan’s stock market was the darling of the investment world.

From 1970 to 1979, Japan’s stock market was up 396% versus the US, which was only up 77%.

Then the 80s happened:

Michael Jackson released Thriller.E.T. was the highest grossing film of the decade.The War on Drugs began.Apple Computer introduced Macintosh.Japan’s stock market remained the darling of the investment world.

From 1980 to 1989, Japan’s stock market was up 1,143% versus the US, which was only up 404%.

Japan’s stock market grew so big that it accounted for 45% of the global stock market cap. The US followed at 33%. Eight out of ten of the largest corporations in the world were Japanese.

And the 90s were interesting too:

The World Wide Web arrived.Friends and Seinfeld ruled TV.We all bought a Discman.Microsoft hit its stride.Global warming became a concern.Japan’s stock market lost itsluster.

From 1990 to 1999, Japan’s stock market was down 7% versus the US, which was up 433%.

The 2000s were globalising:

The iPod showed up, then the iPhone.9-11 shocked the world.Euro was adopted.Google and Facebook connected all of us.The global financial crisis.

From 2000 to 2009, Japan’s stock market was down 30%, the US was down 9%, and emerging markets led the pack, up 162%.

Decade-by-Decade Returns of Global Markets (USD)

Over the course of 20 years from 1970 to 1989, Japan market rose over 6,100%,US market rose 890%,and the rest of the developed world rose just over 1,100%.

How would you have positioned your investments for the future at that point in time? It would have been easy to say Japan was overheating after the 1970s, but you would have missed another ten years of Japan’s dominance.

In the following 27 years from 1990 to 2017, Japan returned a pathetic 120%, The US returned 1,374%,and the rest of the developed world rose 1089%.

Trying to asset allocate tactically by market is no easy feat. Some investors say they want to ‘passively’ own the S&P 500 only, but this is actually an active decision that forgoes most of the world.

We prefer to own a truly globally diversified portfolio - one that we can stick with through geopolitical, economic, and pop culture shocks.

It will likely not be the best performing portfolio at some points in time, as it will be dragged down by its level of diversification. But that being said, it will avoid the far bigger evil: periods of missing out on stock market growth in other parts of the world.

What Singapore-based investors need to know before investing in unit trusts or ETFs

When it comes to investing, Singapore investors have plenty of options to explore since our country is one of the leading financial hubs in Asia. Experienced investors can choose to invest in a diverse range of stocks or bonds, directly on the Singapore Exchange (SGX).

Investors who prefer a more hands-off approach can also invest via their financial advisers, who will normally recommend unit trusts, also known as mutual funds, for them to invest into. Some financial advisers and more recently, “robo-advisors” may also recommend investing in a portfolio of ETFs.

Unit trusts and ETFs are funds that pool together money from different investors for a fund manager to invest, on behalf of the investors, in assets that they believe generate a return for the investors.

Before you decide to park your money in a unit trust or ETF, it’s important that you first understand some of their key characteristics. Doing so can help you identify the right funds to invest in.

Investment methodologyEvery fund has an investment methodology. This methodology should communicate the approach that the fund managers will take for their investment decisions. For some funds, this could be something relatively straightforward, such as investing in the equities of the biggest 30 companies in a particular country or region or tracking a certain index.

Other funds may have their own investment philosophies, such as traditional active stock-picking, or systematic strategies.

For example, Dimensional Financial Advisors (DFA) is a global investment manager that believes that the market is already able to do what they do best – reflect all available information into prices. DFA takes a systematic approach to investing and focuses its efforts on creating more value for its clients through its evidence and financial science-based construction of portfolios, delivered in a cost-efficient manner. They systematically tilt their portfolios to buy more stock of companies with certain characteristics, such as smaller size, value, or profitability. They do so because scientific research has shown that they are the only three proven factors of return that improve returns over the long term. They also believe this is an approach they can stick to, even during challenging market environments.

When you invest in a fund, it’s important that you know and understand the investment methodology of the fund and the track record of the fund managers running it. This methodology has to resonate with you. Otherwise, you will be investing in something that does not make sense to you, and when markets become volatile, you may struggle to stay invested

What the fund is investing inThere is a common misconception among new investors that investing into a unit trust or ETF means you are automatically building in broad diversification for your portfolio. This is not always true. You need to have an overview of what your fund is going to invest in. Typically, this can be segmented into a few key areas:

Location: The area or region the fund invests in. For example, the fund could invest globally or in only developed markets, or focus specifically on regions such as the US or Asia, or just single countries like China or India.

Sectors or themes:The industries the fund can invest in (i.e. technology or healthcare) or thematic funds (i.e. ageing or automation).

Asset classes: Some funds invest strictly in equities only. Some funds invest in bonds or commodities. Others take a balanced portfolio approach, with a mix of both equities and bonds for example.

These are just a few broad areas that you should consider before investing in a fund. You should invest in unit trusts and ETFs which hold assets that you are comfortable owning.

You choose the fund, but the fund manager chooses the underlying investmentsThis simple statement is one that defines what investing in a fund is all about.

When you invest in funds, what you are essentially doing is choosing the fund managers, instead of the actual individual investments. The fund managers then choose what to invest your (and all the other investors’) money in. Even fund managers managing passive index-tracking ETFs will make active decisions in choosing a sample portfolio of securities to best replicate the underlying benchmark, because it may be too costly to mimic underlying indices entirely.

It’s ironic that many new investors do not pay enough attention to who is managing their money. If people who invest directly are already doing so much research on the assets that they are putting their money into, shouldn’t we be doing as much research on the individuals whom we are entrusting our money to?

When you park your money with fund managers, don’t take it for granted that all funds are equal. You should try to find out as much as you possibly can about the fund and the fund managers. Remember, they are the ones responsible for investing your money and making a return for you.

The fees you are payingYou invest because you want to generate a return and grow your wealth. However, if you invest through a unit trust or ETF, you will also incur an annual management fee (also known as the fund’s total expense ratio). Naturally, these fees eat into your investment returns.

New investors sometimes ignore small differences in management fees, thinking that the difference of 0.5% or 1.0% per annum doesn’t really matter. This is wrong.

Consider the example of an investor who invests $100,000 today and earns a return of 7% per annum for the next 30 years. Here’s how his returns will be impacted by just a small increase in fund management fees:

Scenario 1: Fund A charges him a management fee of 1.0%. After 30 years, his portfolio is worth $574,349. He would have paid a total fee of $84,801.

Scenario 2: Fund B charges him a management fee of 1.5%. After 30 years, his portfolio is worth $498,395. He would have paid a total fee of $116,129.

Scenario 3: Fund C charges him a management fee of 2.0%. After 30 years, his portfolio is worth $432,194. He would have paid a total fee of $141,521.

The management fee is just one type of fee that you pay. For unit trusts, other common fees include initial sales charges, payable when you first invest, wrap fees, as well as redemption charges, which may apply when you redeem units. For ETFs, you will be charged a brokerage fee when you buy or sell. All these additional costs will eat into your investment returns.

In the example above, you can see that a difference of 1.0% per annum in management fee works out to be more than $142,000 difference in returns over a 30-year period. This is based on an initial investment of $100,000 and a return of 7.0% per annum. If the investment is larger and the returns are higher, the fees will be higher as well.

Invest wiselyAt endowus, we believe that for long-term, buy-and-hold investors who do not need intra-day trading liquidity, it may be more effective to invest in unit trusts which trade at NAV, rather than trying to time the market when you invest in ETFs and potentially paying more than what the underlying assets of the ETF are worth.

At the same time, we believe in keeping our costs low, so that our clients keep more of their returns. Our all-in Access Fee is from 0.25% to 0.60%, depending on your assets under advice. This all-in Access Fee includes advice, investment, rebalancing, transfer and brokerage, all at a fraction of the industry average. On top of this, you pay a fund-level fee of between 0.50% to 0.56%, which is charged by the fund managers out of the fund’s daily NAV.

What to expect when you're expecting

We are creatures of habit. When you go to your favourite coffee shop, you expect to get that same coffee, made by that same barista. When you go to that Thursday morning yoga class, you expect to see your favourite yoga instructor. When someone you have never seen before skips into the room and takes the instructor mat, you sigh a little and shake your head before getting on with the class.

When you invest, you expect to get the return due for the risk taken. An example: if you buy an index fund or ETF tracking the MSCI All Country World Index, you will expect it to give you an annual return in-line with its long-term average (minus costs). Though the long-term average is an indicator of what to expect in the long-run, there are very few single years of return that will fall anywhere close.

MSCI All Country World Index annual return minus average annual return (USD)

In the 23 years from 1995 to 2017, only 6 years fell within a 10% range (+/-5% radius) of the long-term average annual return of 9.12%.

Furthermore, the best and worst 12-month return in the period ranged from +59.0% to -47.9%. This is an enormous dispersion of returns.

Each year is made up of 365 days of ups and downs, sweaty palms, hair-raising news, and your beating heart. It is not easy to patiently allow the fluctuations to work themselves out.

Diversification does remove some volatility, but if you expect to achieve anything close to the average annual return every year, you will be sorely disappointed and should probably steer clear of equity markets.

Ignore the desire for gratification in getting what you expect and try to ride out the market fluctuations, knowing that you have positioned yourself for long-term investment success.

“I think it may be true that fortune is the ruler of half our actions, but that she allows the other half or a little less to be governed by us.”- Niccolo Machiavelli in “The Prince”

On June 3, 2017, Alex Honnold scaled El Capitan “free solo” without a rope: he climbed a 3,000-foot vertical granite wall with his bare hands and some chalk, in what is probably the most impressive feat in sporting history. 3 hours and 56 minutes of sheer concentration, strength and most importantly, skill.

Buying Tencent a year ago at $354, and watching it go up 34% in 3 months to $474, then crash 40% to $282 - that can be attributed to good luck followed by bad luck.

The influence of luck on outcomes has been understood for a long time. Despite having every manipulative trick up his sleeve, political mastermind Niccolo Machiavelli acknowledged the role that luck played in successful outcomes in his handbook for future rulers. Five centuries later, Michael Mauboussin wrote about the difficulty of distinguishing luck from skill in business, sports and investing in “The Success Equation”. He shows how different activities sit on the scale of luck and skill: Chess sits on the far right of the chart (pure skill), and slots machines sit on the far left of the chart (pure luck). Where does investing fall on this scale?

Nobel Laureate Eugene Fama and Ken French published a paper ‘Luck versus skill’, where they analysed the performance of over 3,000 US mutual funds from 1984-2006 through the lens of their Fama-French 3 factor model (i.e. adjusted the performance for the excess risk that the funds took).

They discovered that in aggregate, the entire active fund universe underperformed the market by about the fees they charged their investors.

Naturally, some funds outperformed and some funds underperformed. How much of that outperformance was due to skill and not luck? Professors Fama and French determined that only the top 3% of mutual funds outperformed consistently net of fees. But “the number that did outperform the market with a high degree of certainty was less than what is expected by random chance.” (Source: IFA)

Mauboussin believed that the reason why luck is so important in investing is not that investors are not skilful - it’s actually the opposite.

Imagine if AlphaGo, Google DeepMind’s champion-beating computer program, played against itself. The winner of each game would be more dependent on luck, as skill would be the same. This is an extreme example, but the same applies to investing.

Investors are smarter, more skilled, and have access to more information today. Collectively they have become more efficient at incorporating information into stock prices. As a result, the outcome becomes more uniform with less dispersion of good and bad outcomes. Mauboussin calls this the paradox of skill (Source: CNBC):

As skill improves, as the average skill level improves, it actually increases the dependence of luck in determining results. Perhaps recognizing the importance of luck in investing (and life) is a skill in itself.

The more dependent an outcome is on luck, the more important it is to focus on the process. If you rely solely on luck, you may get to a good (or poor) outcome with some random probability.

A good process will give you the highest probability of achieving successful outcomes over the long-term. If markets have taught us anything - it is to be humble and admit that we are not all ‘above average’, and we do not know what the future holds. Instead of gambling our hard-earning savings and relying on luck, we would rather invest with and stay committed to an evidence-based disciplined process.

He started investing at the end of 1972 with $100,000, right before the US market fell almost 50% over the next year.

He then invested $100,000 in 1987 (after 15 years of saving), right before the market lost over 30%.

His bad luck continued: He invested $100,000 at the end of 1999, just to see the market lose half its value again.

His final investment before he retired was made in 2007, where he invested the $100,000 he had been saving since 2000. The markets delivered him another >50% loss.

Poor Bob was also unlucky in life.

At the beginning of 2009, after the markets were down 51% since his last investment, Bob was on a ski vacation and had a bad fall. He needed to have a hip replacement, and when he got home, found that his house had burned down.

Bob looked to his investment portfolio and was surprised to discover that he was actually a multi-millionaire - $2.44 million to be exact. He made 6.1x his money despite his terrible luck with a 7.98% annualised return (IRR).

Thinking about inheritance, Bob did not touch his hilariously poorly timed investments and instead decided to live with his children and claim insurance for his hip replacement. As of end September 2018, Bob’s holdings would be worth $11.8 million, 29.6x his initial investment, with a 10.28% annualised return (IRR).

Bob wasn’t such a schmuck after all. He saved diligently and never panicked, which allowed the power of compounding to work for him.

In fact, Bob did a lot better than many of us. According to JP Morgan’s Guide to Markets, the average investor had a 20-year annualised return of 2.6% as of June-end 2018, likely due to speculation and poor investment behaviour.

Market timing is the holy grail of money-making - who doesn’t want to buy low and sell high? But it is impossible to get right consistently. You’re investing for the next decade or two, not the next month or year. When the powerful financier J.P. Morgan was asked what the stock market would do next, his answer was “It will fluctuate.” Look at the long-term trajectory of the markets rather than short-term fluctuations.

It’s about time in the markets, rather than timing the markets.

If you hold cash for long enough, you will eventually see markets decline. But you’re betting that you know when the markets are near a peak or trough, and that the pullback will compensate you for the close-to-zero return you’ll get sitting in cash, and that you’ll have the discipline to put money back to work when it falls by a certain level, even if everyone else is taking it out.

Pundits have been predicting for years that a market crash is right around the corner. They’ll eventually be proven right because that’s how markets function. Worrying about investing at the peak of the market is distracting you from what you should really be thinking about: positioning yourself in the markets for the long-term to have the greatest chance of success.

Do Crazy Rich Asians only invest in real estate?

Owning real estate has been heralded as the ‘best’ way to grow your wealth. But is it really better than investing in the market?

TAKEAWAY OF THE WEEK

Unless you’ve been living in a cave, it’s probably safe to say that even if you haven’t watched Crazy Rich Asians, you’ve heard about it. It’s both a depiction of the life of the 0.1 percent and a marketing coup for the Singapore Tourism Board. The Youngs are absurdly rich, and one of the most opulent symbols of their wealth is the matriarch's family mansion at Tyersall Park. It’s an over-the-top, sprawling home in Peranakan style, and so secluded that it can’t be found on Google Maps.

Owning real estate, or in this case, a mega-mansion, has always been a status symbol in Asia. It’s heralded as the ‘best’ way to grow your wealth, and if all else fails, it’s a fixed asset and roof over your head. Many of the real ‘Crazy Rich Asians’ have indeed built their fortunes on real estate. But is it really better than investing in the market?

You would think that Hong Kong real estate blew stocks out of the water, but this is a misconception.

We always hear wonderful 'get rich' stories on fabulous property purchases, but looking back at the data, they were more likely just fabulous acts of holding on.

Here are some things to think about when investing in property:

Leverage - This is perhaps the largest driver of outsized equity returns in owning real estate, and also the biggest trigger for the 2008 Global Financial Crisis. If you pay $250,000 for a $1 million property, and the value goes up by 10% ($100,000), you have effectively made a return of 40% on your initial investment (excluding any interest costs etc). It’s quite unlikely you will lever your investment portfolio 4x. Remember, leverage is a double-edged sword that will also amplify your losses in a downturn.

Liquidity - Stocks are far more liquid than real estate investments, and prices are transparent. You can buy or sell stocks anytime during market hours, and you can see the bid/offer spread on your screen. You can list your property for months without any buyers, or perhaps the best ‘offer’ for your property is vastly different from the last transacted price. However, the ease of trading stocks also means that you are more prone to poor behaviour and the whims of your emotions. It’s far easier to sell off your investment portfolio in a panic - all you need is a few clicks. You can’t really sell a property in 5 minutes.

Real estate forces you to behave as a 'good investor' given its frictions. Imagine if you had the same frictions when it came to investing in the stock market?

Diversification - Adding real estate as an asset class to your overall investment portfolio can offer diversification benefits. However, unless you are in fact a Crazy Rich Asian who can afford properties in different cities around the world, it’s difficult to diversify within your real estate investment. For most of us, buying one property will make up the majority of our net worth. It’s much easier to diversify when you invest in stocks - you can buy shares of a globally diversified fund with thousands of holdings with just a small amount of cash.

Income - Both stocks and real estate investments can generate steady income from dividends and rental income respectively. There are different risks involved: dividend payouts are not guaranteed, and the amounts are subject to the underlying company’s discretion. Rental yield is subject to supply and demand dynamics of the real estate market, and there can be periods when your property can’t be rented out at all.

Holding and transaction costs - There is a cost to holding real estate - you have to pay maintenance fees, utility bills, insurance, property taxes and more. It’s also more hands-on work - you have to deal with leaking aircon units, clogged bathrooms, and pest infestations in the garden. Transaction costs are also much higher for real estate - Singapore property agents on average charge 2% to broker transactions, and there are additional stamp duty costs.

Investing in real estate should rightfully lead to higher returns because you should be compensated for the illiquidity and transaction costs, but that is not always the case. There was a study done entitled “The Rate of Return on Everything, 1870-2015”, where researchers looked at 16 advanced economies over the past 145 years. They adjusted the returns for inflation, included dividend income for equity returns and rental income for residential real estate returns.

Both real estate and publicly traded securities are better investments than staying in cash, and both have a place in your portfolio and in your life. Owning properties is the Asian dream but there are alternatives to think about before just the diving in.

We can all retire as multi-millionaires

It may feel almost too overwhelming to think about saving a million dollars for retirement, especially when it’s still decades away.

TAKEAWAY OF THE WEEK

You can’t just wake up one morning and decide to run a marathon. You set yourself a series of smaller goals before you can get there - from dragging yourself out of bed every morning to train, to building up your stamina and adding more miles to each run.

The same philosophy can be applied to saving for retirement. It may feel almost too overwhelming to think about saving a million dollars for retirement, especially when it’s still decades away.

Time matters.

Time is your biggest ally here in building up a retirement nest egg. Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” Here is what setting a series of smaller savings goal can get you:

Age 22: You’ve just entered the workforce with a monthly salary of $3,400 and two months of annual bonus (median salary for fresh graduates in Singapore). You save 24% of your salary (average savings rate in Singapore) and have made the smart decision of investing your savings into an 80% stocks and 20% bonds portfolio.

Age 29: By diligently investing your savings every month, you have now reached your first small goal of saving over $100,000.

Age 40: You have just hit the $500,000 mark.

Age 47: Congratulations! You are now officially a millionaire.

Age 60: The effects of compounding have snowballed. You have now saved over $3 million.

Age 65: It’s time to enjoy the fruits of your labour - you can retire with a nest egg of over $4.5 million. Assuming annual inflation rates of 3%, this is equivalent to ~$1.26 million in today’s money. For Singaporeans, this excludes what you have in your CPF, where you have been saving 37% of your monthly salary until you were 55. Imagine how much more you could have to spend in your retirement if you had invested part of this.

This assumes your annual salary increases 3% per year and annualised long-term returns of ~7% per annum for your 80% stocks and 20% bonds portfolio. Returns in any given year are far from average, but we are investing over the long-term. As a reference, the average annualised returns for the S&P 500 since its inception in 1928 is ~10%.

There’s a nifty math shortcut to see approximately how long it will take to double your portfolio - just divide 72 by your rate of return. I.e. if you can earn an annualized return of 7.2% on your portfolio, you will double your money every 10 years.

Doubling your money every 10 years by taking some market risk is totally doable.

Unfortunately, you can’t just wake up one morning and decide to be a millionaire today, a year later, or even 5 years later. Your get-rich-quick plan probably isn’t going to materialize. We have written about the impending pension crisis and how we should all prepare better for our retirement. (You can read about it here).

Start small. Start early.

Harness the power of time in the markets and the snowball effect of your money working for you.

Getting to that money/hammock moment

While research has shown that passive investing makes sense for part of your stock portfolio, we think it’s a different story for bonds.

TAKEAWAY OF THE WEEK

Warren Buffett thinks that the smartest thing your money can do is climb into a hammock and take a nap. (Of course, he’s smarter than us so he doesn’t do this personally.) While research has shown that passive investing makes sense for stock investing, we think it’s a different story for bonds.

Let’s look at the numbers: Over the past 10 years in the US, the median active bond fund manager has outperformed the median passive bond fund by 0.80% per annum after fees (a meaningful amount). This is compared to the underperformance of the median active stock fund manager versus the median passive stock fund of 0.56% per annum.

We would love to embrace Warren Buffett’s romantic laissez-faire view on investing in its entirety, but as evidence-based investors, we think a little more work is required before shutting both eyes and dozing off.

Not all asset classes and markets are created equally. The bond market is a different animal from the stock market in many ways:

1. Irrational players.

There are ‘noneconomic’ players moving huge amounts of money that do not always act rationally in the economic sense. Central banks prioritize their country’s growth and inflation mandates over portfolio returns. For example, when central banks implemented quantitative easing policies, they bought their own government bonds to boost spending in order to reach inflation targets and stimulate economic growth. This ‘irrationality’ affects the market.

2. Bonds are rated.

In the stock market, the price of a stock reflects all known information on the company. For some reason, we humans decided not to place our trust in the power of markets when it comes to bonds - we allow ratings issued by organisations to help the world decide the ‘quality’ of a company’s bond. Funnily enough, these ratings almost always lag changes in a company’s bond price, which means that the market participants see the changes in a company’s fundamentals before the rating agencies can get around to changing their laggard ratings.

Benchmark indices have to track these imperfect ratings religiously, which is inefficient. We prefer to leverage on the collective wisdom of the market and use the information in prices, as we do for stocks. This means having someone in the driver seat of our bond portfolio so we are not stuck behind an old smoke-spewing truck (the rating agencies and indexes that must adhere to their judgement) when the light turns green.

3. The (lack of) fees.

The general rule is that if fund managers can get away with high fees, they will. Luckily for us, over the years they have lost the ability to justify their high fees due to a lack of outperformance, which has put downward pressure on their share of the pie. The fee dispersion between active and passive managers in bonds is much smaller than in equities, and at a level where active bond fund managers are taking home less (in their fees) than their median outperformance over their benchmarks.

Change is the only constant in life

‘Passive’ and ‘index fund’ are usually joined at the hip, but in reality, the underlying components of an index fund are far from passive...

TAKEAWAY OF THE WEEK

AP Photo/Evan Vucci

Trump and Kim: from ‘totally destroy’, to ‘new relations’ and a 13-second handshake. The only thing constant in our world is change.

In the media, ‘passive’ and ‘index fund’ are usually joined at the hip, but in reality, the underlying components of an index fund (ETF or unit trust) are far from passive. The index components are operating companies, and as operating companies are run by humans: the companies do things like merge, privatize, go bankrupt, or buy back their own shares. Big companies shrink and small companies grow. New companies float on the market and the indexes that the tracker funds are meant to track change. If you were truly passive and did nothing at all, your holdings would cease to resemble the market.

Unless you are day trading, you most likely had fewer than 24 changes in your portfolio holdings in 2015.

Unfortunately with all this change (which the industry calls index reconstitution), the index funds are constantly having to play catch-up. Index tracker funds are forced to buy or sell these securities to minimize tracking error (deviation from the benchmark index returns). The turnover cost can be split into two: brokerage costs and market impact. We’ll focus on the latter as brokerage costs should be minimal for large index providers.

Index reconstitution is generally announced ahead of time to allow fund managers to rebalance their portfolios. But as you can imagine, there will be a great demand for securities that are being added to an index, and pressure to sell securities that are being dropped from an index, even if there are no changes to the company fundamentals. Prices react predictably to the new supply-demand equation. On June 4th, it was announced that Twitter would replace Monsanto in S&P 500. The share price of companies being added to major indexes usually spike up, and this was no different. Twitter’s shares climbed in post-market trade after the announcement, and surged nearly 5% the next day.

In a paper published by New York University professor Antti Petajisto in 2010 on index turnover cost, he estimated that the annual turnover drag for the small-cap Russell 2000 was ~0.38%-0.77% and for the S&P 500 ~0.21%-0.28%. You can see that the cost is much more pronounced in higher turnover indexes that track less liquid securities. Index turnover for S&P 500 is relatively low, but this is not always the case. Small and midcap ETFs have higher turnover for example, because the companies have a higher propensity to be bought out or go out of business versus the large-caps sitting in the S&P 500. The index turnover cost will also be higher in emerging markets, more niche sectors, and bonds. We will focus more on the bonds space next month.

The rise of low-cost indexing has democratized access to capital markets and reduced the cost for all of us to manage our assets with meaningful diversification. Indexing has been so successful that you can now track everything from robotic companies to hedge funds. It’s great that you and I can now access parts of the market that would not have been available to us before, but it’s important to remember that index turnover costs for more niche strategies or markets can be significant. Interestingly, the number of indexes in existence today far surpasses the number of single securities: with 3,000 easily investable stocks, the number of possible combinations to turn into an index is a Googol, or 1 followed by 100 zeros. (Source: Bloomberg). Fees for index tracker funds with low turnover and more actively traded underlying components are reasonably low; but indexing is not, as many people believe, ‘basically free.’

Finding patterns where there are none

We humans are wired to find patterns, even when they don’t exist. It’s why people see faces in nature, religious figures on toast and come up with...

TAKEAWAY OF THE WEEK

Jackson Pollock photographed at work by Hans Namuth

Let’s play a few rounds of roulette. Which outcome is more likely?

Red | Red | Red | Red |Red |Red |Red |Red

Red | Black | Black | Red | Black | Red | Red | Black

The first outcome seems rigged. Intuitively, the second outcome seems more likely because it looks more random and exhibits less of a pattern. But in reality, both outcomes are equally likely. Each roulette spin is independent, and on each spin you have a 47.4% chance of hitting red or black. The outcome of each spin is not influenced by the previous spin, and cannot affect the upcoming spin in any way. The belief that if something happens more frequently than normal during a given period, it will happen less frequently in the future is called the gambler’s fallacy.

We humans are wired to find patterns, even when they don’t exist. It’s why people see faces in nature, religious figures on toast and come up with conspiracy theories. (Read Scientific American for more on Patternicity) When Apple first launched the iPod shuffle, people complained that the ‘random shuffle’ wasn’t random enough because they would sometimes hear the same song twice. The truth was, Apple did too good of a job in making it truly random, which meant that it didn’t take into consideration whether a song had been played recently. They had to later change their algorithm to be less random to seem more random.

We also tend to make investment decisions based on seeing historical patterns and trends that may amount to little more than random chance. We love to draw price charts and find ‘Head and Shoulders’, ‘Double Bottom’, or ‘Triangle’ patterns, then predict where prices will go. But this is largely an exercise in futility. British mathematician and philosopher Frank P. Ramsey proved that randomness will always exhibit some patterns, no matter how complicated you make a system. Basically, he showed that given enough variables to play around with, you can find any pattern you want.

We try to find rhyme and reason in everything. Things happen and we look for an explanation, finding meaningful patterns in meaningless noise. It is important to ignore the noise, stay disciplined in following time-tested empirically-proven investment plans, rather than be swayed by your human condition.